Wednesday, April 22, 2015

One category of investments that are popular with investors and have done well over the years are the Sin Stocks. These are investments in industries and sectors that are considered unethical or immoral, which include companies in alcohol, tobacco, sex-related, weapons manufacturing and military industries. This post will take a close look at the tobacco industry and presents some of the risk/reward considerations to keep in mind and evaluate: are tobacco stocks still a good investment?

I personally have no qualms about investing in the sin stocks for the sake of ethics, as any company that is worth its salt is probably stepping on other's toes. The business world is brutal - and needs to be, in order to survive and be successful. Jason at Dividend Mantra had a post touching on this subject recently - entitled How Ethical Can an Investor Be? I agree with his points where he points to the questionable behavior of smartphone sweatshops and other industries. Same goes for the industries that most people consider benign, such as say, the food industry - if anyone takes the time to look into how animals are raised in our current conventional animal farming, it is truly horrifying. But that is a story for another post. Let's jump into the subject of tobacco stocks.

Past Returns

Credit Suisse recently published a brilliant investment report entitled Credit Suisse Global Investment Returns Yearbook 2015. If you haven't read it, I invite you to do so - it is worth your time. In that report, they evalate the performance of industries in USA and find that the tobacco industry had the best returns from 1900 to 2014. $1 invested in 1900 would have turned to $6.2M in 2014, representing an annualized return of 14.6%, which was 5000 times as much more profitable than the worst performer - Shipbuilding and Shipping.

Performance of US industries 1900-2014 (Source: Credit Suisse)

Those numbers should make any investor salivate. But it is also important to keep the historical context in mind - cigarettes were 'physician tested and recommended' for a better part of the century. Here is a detailed account of the tobacco industry's timeline over the 20th century. Even though there was evidence of linking lung cancer to tobacco as early as 1912, it took a better part of the century for the medical community to officially acknowledge it and finally the tobacco industry caved accepting that fact that their product might be the cause.

The Giants

The tobacco industry consists of a few major players. The largest players are Altria Group (MO), Philip Morris International (PM), British American Tobacco (BTI), Imperial Tobacco (LON: IMT), Japan Tobacco (TYO: 2914), China Tobacco (private), Reynolds American (RAI), and Lorillard Inc (LO). The industry is seeing some consolidation and spinoffs of late. Altria (MO) spun off Philip Morris International (PM) in 2008 for its international operations, which has already made PM the largest (public) tobacco company in the world. In 2014, Reynolds American acquired Lorillard in a $27.4B deal.While the shareholders have agreed to the terms, the FTC is still weighing the settlement terms.

Company, Ticker, Market Cap, Yield

Philip Morris, PM, $119B, 5.14%

Altria Group, MO, $100B, 4%

British American Tobacco, BTI, $98B, 5.8%

Reynolds American, RAI, $39B, 3.66%

Lorillard Inc, LO, $24B, 3.78%

Imperial Tobacco, LON:IMT, $30B, 4%

Japan Tobacco, TYO:2914, 7.7T, 3.08%

Are Tobacco Stocks Still A Good Investment?

Current Trends - Volume

The current statistics indicate that the number of smokers have been declining worldwide. This report from WHO is one of the most extensive reports which confirms that claim of declining users. There have been other reports which confirm this trend, but in order to be balanced, I want to present one conflicting report that I came across when discussing about the trends. This report from The Journal of the American Media Association (JAMA) presents that the number of smokers is actually rising. But looking at the annual reports from Philip Morris (PM), Altria (MO), Reynolds American (RAI), Lorillard (LO) and British American Tobacco (BTI) all suggest that the trend is quite obvious - each of those companies is seeing declining volumes year over year. One wildcard here is the Chinese market - which has over 350M smokers and most of the market belongs to the state-run company China Tobacco (CNTC), so the market is off limits to most investors. The one interesting take here is that there exists a strategic partnership between PM and CNTC, which allows them to use the Marlboro name.

Current Trends - Prices

The cigarette companies have been more profitable than ever before. This has been possible, even taking the falling volumes into account, due to rising prices. The aforementioned and linked annual reports from the cigarette companies will show that the price per pack has been rising over the years. This report from CDC also confirms that the volume of sales has been declining and the price per pack of cigarettes rising over the years.

Current Trends - Legislation

Most of the world recognizes the negative effects of cigarettes and has taken steps to combat the usage. Western governments have banned cigarette advertising for a while now and legislated plain packaging or severe warning messages and/or grotesque pictures on packages. In addition, legislation has been introduced in a lot of cities/states to ban smoking in public places. Even emerging markets such as Russia and China have recently announced initiatives to educate the masses about the dangers of smoking and are in the process of introducing advertising bans. This makes a lot of sense for governments as it puts unwanted burden on the tax-sponsored healthcare systems. However, the presence of economic and trading partnership agreements, which gives corporations power way beyond a country's own legal system has allowed the tobacco firms to sue governments and muscle their way into the country. This video from Last Week Tonight captured the essence of the power that a tobacco corporation has over a country. More recently, Philip Morris has announced that it is suing Uruguay over its health warning legislation. In the future, I believe agreements such as Trans-Pacific Partnership (TPP) and Tranatlantic Trade and Investment Partnership (TTIP) will give corporations more power allowing them to take countries to court and sue them.

My Take

I am skeptical about investing in the tobacco industry. As the masses become more aware and health conscious, the usage has steadily decreased. I think there is a case for investing in tobacco and should not be completely discounted. A small portfolio exposure would serve well for most dividend investors. Some companies such as PM have the extra dimension of currency pressure - which need to be considered by investors (the company has operations only outside US, but reports in US$...and with the strong US$, that puts a damper on the earnings). Considering the headwinds faced by the tobacco companies worldwide, it will not be surprising to see more M&A activity in the future. However, it is important for potential investors to keep in mind that the industry faces declining volumes, legislative actions and other roadblocks.

What are your thoughts on the industry? Do you agree with my take? Share your thoughts below.